Let us assume that you bought a stock and the stock price went down. What should you do? Should you exit the stock, should you hedge your position or should you simply average the stock at lower levels. Obviously, there are no easy answers to this question as there are too many open-ended issues here. The common approach is that when you bought a stock and it went down, you were wrong in the first place. Therefore, averaging the stock would be equivalent to being wrong twice. That may again be a very simplistic argument. There are four key issues that you need to consider when you take a decision to average or otherwise on your position...
Has the stock gone into an intermediate downtrend?
The most common dilemma of averaging is when you bought a stock and the stock goes down. The key question is whether the stock has gone into an intermediate downtrend. This has nothing to do with the quality of the stock or the quality of the management. Both these may be favourable and yet averaging may be the wrong choice. Consider the case of L&T in 2011. The capital cycle was turning down and investors suddenly realized that L&T will not be able to maintain its growth and margins to justify its valuations. The stock lost more than 50% over the next couple of years. When the underlying trend shifts, there is no point in averaging. Second is a case where something is changing fundamentally. Take the cases of IT and pharma over the last 18 months. Marquee names have lost over 50% value purely because the regulatory environment was getting tougher and margins were getting thinner. When there is such a fundamental change, you must avoid averaging your long position.
What about averaging your short position? Watch out if the stock is breaking out with higher volumes. In that case, averaging your short positions can be disastrous. Reliance in the last 8 months and Maruti in the last 18 months are classic cases in point. If you were short on either of these stocks, you would have ended up in huge losses by averaging your short positions.
Is averaging exposing my portfolio to concentration risk..
This has less to do with the fundamental shifts in the stock and more to do with your own portfolio mix. Assume that you are having a 20% exposure to the banking sector. That is normal for a diversified portfolio considering that banking has a similarly high weightage in the Nifty too. However, if you continue to average your banking positions and that takes your exposure in banking to 40% then you have a serious concentration risk on hand. Your concentration risk should also be seen in the context of the sensitivities of the mix to external stimuli. For example, even though your banking mix is 20%, you have added stocks of NBFCs, HFCs, auto companies and real estate companies and the combined share of these sectors is now 50%. Now, all these are rate sensitive sectors and can react negatively if rates were to go up or even if the RBI was to use more hawkish language. This one more thing you need to consider while averaging.
Avoid averaging when macro risks are very pronounced..
Macro risks can come in a variety of forms. For example, a decision by the RBI is a macro risk. The failure of monsoon or the plight of farmers can also be a key macro risk. The $90 billion of NPAs that Indian banks are sitting on can also be a macro risk. Similarly, the macro risk can also come from political developments like change in government, shift in policies, anti-reformist tilt etc. Lastly, risks can also come from global events. A sharp spike in oil prices can be negative for the macros of the Indian economy. Geopolitical risk in West Asia and the Middle East is also a key risk for Indian economy. Typically, these are volatile situations and can make the markets behave in a very erratic fashion. When the macros are volatile, then traders should avoid averaging both long and short positions in the market.
Using Averaging constructively..
The idea is to use averaging constructively and to your long-term benefit. There are stocks that have a lot of momentum in their favour. You will also be in doubt as to what is the right price to buy these stocks. One of the ways of addressing this dilemma is to average stocks each time it gives a correction. This will ensure that the long-term average cost of acquisition of the stock is at the lower end. The beauty of momentum is that such stocks become over-owned quite fast. It therefore provides an opportunity in the form of intermittent corrections that can be used to keep accumulating the stock at more attractive levels. It will help you reduce your average cost of holding the stock.
Many traders use the 100-DMA (day moving average) and the 200-DMA as a decision point on whether to average or not. Remember, that is a technical approach and does not capture long term shifts in underlying fundamentals of the stock. DMAs can be a good starting point but beyond that you need to apply the above rules to take a final decision on whether to average your position or not. Remember, average can work both ways!